An Internet tool for entrepreneurs
to gather small donations got a big boost April 5 when President
Barack Obama signed legislation allowing companies to sell
equity through crowdfunding websites.
While the law is designed to help young companies grow and
create jobs, it may lead to a rise in scams and losses for
investors, according to state securities regulators and
attorneys. The Jumpstart Our Business Startups Act also eases
funding rules for closely held firms and newly public companies.
“States are concerned that the fraud and scammers will
come out of the closets now and start using the social-
networking sites to rip off investors,” said Jack Herstein,
president of the North American Securities Administrators
Association. State regulators reported almost 3,500 enforcement
actions and ordered more than $14 billion in investor
restitution in 2010, according to a NASAA survey.
Crowdfunding websites, which have sprung up in the past
several years, list offerings from businesses trying to raise
small dollar investments from hundreds or thousands of people
through the Internet or social-media platforms. Until now they
had been able only to take donations from the public, sometimes
providing perks such as their product in return.
The bill permits startups to pool capital through
crowdfunding by selling as much as $1 million in securities a
year. Investors may be able to profit by selling the shares
after a required yearlong holding period or if the company
eventually goes public. The websites usually charge the
businesses a fee or take a percentage of the money raised for
Many of the details around how crowdfunding will work are
unclear because the U.S. Securities and Exchange Commission has
about nine months to write rules. Businesses would have to reach
at least a target offering amount before giving people equity,
according to the legislation.
The law also limits how much a person can contribute
through crowdfunding. Investors with annual income or net worth
of less than $100,000 will be allowed to invest the greater of
$2,000 or 5 percent of their income or net worth a year. People
with more than $100,000 can invest as much as 10 percent of
their income or net worth, up to $100,000.
“That helps tremendously in reducing the damage a huckster
can do,” said David Marlett, executive director of the National
Crowdfunding Association, which formed in March.
Individuals contributed about $123 million through
crowdfunding globally last year, a 284 percent increase from
2010, according to Daily Crowdsource, a San Diego-based firm
that produces industry research and news.
Kristine Singer, a consultant from Miami, gave $75 through
Indiegogo.com to a business raising cash to market the Scrubba,
a small bag designed for travelers to wash clothes on the go.
“There are a lot of great products and a lot of people
with great inventions,” said Singer, who lives on a sailboat
and expects to get two Scrubba bags in return for her donation.
“To also receive profits back in the future if they were able
to grow, that would be a win-win for everybody.”
The legislation increases the likelihood that individuals
will invest in startups and lose money because the companies are
riskier, said Barbara Roper, director of investor protection at
the Washington-based Consumer Federation of America.
“Crowdfunding is something I would say has precisely the
same place in the average person’s investment portfolio that
lottery tickets do,” Roper said. “If you have a little spare
cash that you think it would be fun to gamble with that’s fine,
but don’t consider it part of a well-thought-out investment
The bill prevents states from policing crowdfunding
offerings until an alleged fraud has been committed, so people
will need to do more research before they use the online sites,
said Herstein, who’s also an assistant director with Nebraska’s
department of banking and finance.
“The last few years have been pretty tough on
entrepreneurs,” Obama said at the signing of the law. “Because
of this bill, startups and small business will now have access
to a big, new pool of potential investors — namely, the
American people,” he said. Websites used to pool funding will
be subject to “rigorous oversight,” the president said.
Singer said she wasn’t worried about fraud when she
“It’s kind of like EBay (EBAY),” she said. “If you can trust
the site and it’s as transparent as it can be, it’s not really a
Investors in shares of non-publicly traded stock are
generally entitled to the same tax treatment that people use for
publicly traded securities, according to the Internal Revenue
Service. That means profits from sales usually are taxed at
capital gains rates, currently a maximum of 15 percent for those
held more than one year. There also are limitations around how
much any losses that exceed gains may be deducted against other
income such as wages.
Unrealistic expectations may be a bigger issue for people
who invest through crowdfunding rather than fraud, Steven Dresner, founder of DealFlow Media in Woodbury, New York, which
is a research and database firm that tracks equity-linked
“There’ll be far more instances where people invest in a
crowdfunded project and then realize that it’s really hard to
make a profit,” Dresner said.
Less than half, or 45 percent, of businesses founded in
2004 were still around five years later, according to a 2011
study by the Kauffman Foundation, a nonprofit dedicated to
Investors should make sure they receive disclosures about
how shares are priced and any updates such as management changes
between the time of their pledge and the closing of a
crowdfunding deal, Dresner said. They also should understand the
rules around canceling a commitment, said Dresner. Those details
may be worked out in the SEC rulemaking, he said.
The law also lifts a ban on the marketing of private
offerings to the general public.
In the past, securities laws generally required firms to
market non-publicly traded securities only to so-called
accredited investors with whom they’ve had an existing
relationship. That generally means individuals with assets of
greater than $1 million, excluding a primary residence, or those
earning more than $200,000 annually. The solicitation rules were
designed to protect the average investor from deals with less
disclosure and higher risks.
’Blanket the World’
While firms can now market to anyone, they still must sell
private offerings only to accredited investors, said Mercer Bullard, an associate professor of law at the University of
Mississippi. That distinction will be difficult for regulators
“If you’re a fraudster you just blanket the world with
solicitations,” said Bullard, who’s also founder of the
investor advocacy group Fund Democracy. “As soon as the money
comes in from non-accredited investors you collect it and shut
down your operation as soon as any heat is brought to bear.”
People living in wealthier retirement communities can
expect to start receiving solicitations to invest in private
offerings as a result of the law, said Roper of the Consumer
Federation. “They should treat them exactly like they treat the
rest of the junk mail they receive,” said Roper. “Throw them
right into the trash can.”
The legislation makes private offerings more democratic,
said Greg Brogger, president and founder of SharesPost Inc.,
which facilitates transactions in private-company stock such as
shares of Facebook (FB) Inc. and Twitter Inc. for accredited
investors. Facebook has filed to sell shares in the largest
initial public offering of an Internet company.
“Instead of a private, closed club of who you know, now we
have the opportunity to much more broadly disseminate offerings
of private securities,” Brogger said. The new law means
SharesPost, based in San Bruno, California, will be able to
market its offerings to an additional 70,000 members who haven’t
yet submitted the documentation to show they’re accredited,
SharesPost and its president settled with the SEC in March,
agreeing to pay $100,000 to resolve claims that the firm acted
as an unregistered broker in 2010. The SEC scrutinized trades
before the firm became a broker-dealer and used a third party to
act as its agent. SharesPost was granted broker-dealer status by
the Financial Industry Regulatory Authority in December.
Eric Tolbert, 44, is an accredited investor and former
chief financial officer for Massey Energy Co., who said he’s
using a website run by WealthForge Holdings Inc. to find out
about up-and-coming companies. WealthForge matches investors
with entrepreneurs raising money through private offerings of
stock, debt or convertible notes, said Gregory Gulling, vice
president of marketing for the Richmond, Virginia-based firm.
“This provides a different way to match up investors and
companies that we haven’t had before,” Tolbert said, who
decided to invest in the website itself after joining. “You’re
not looking all over the place or having to know a friend of a
Investors should still do their own due diligence because
of the risks with startups, said Tolbert. They should look at
the potential for future cash flow, the company’s leadership and
what progress it’s made so far, he said.
When startups or small businesses eventually go public,
many of them won’t have to provide as much information to
investors at the outset because of the law. Businesses with less
than $1 billion in revenue that make a public offering will have
up to five years under the new legislation to comply with
certain accounting rules and disclosures of executive
compensation, said James Cox, a professor of corporate and
securities law at Duke University.
Some IPOs may voluntarily provide the information that
“grown-up” businesses do because investors may demand a risk
premium from those that don’t, Kathy Smith, principal at the IPO
investment adviser and research firm Renaissance Capital LLC in
Greenwich, Connecticut. People should look for those companies
that are more forthcoming because if they’re capable of going
public they should be able to provide the financial statements
and disclosures that have been required in the past, she said.
Investors should be aware that newly public companies are
the most volatile category of equities because they’re the least
well known, said Smith. Stocks of companies that went public in
the U.S. this year returned about 21 percent on average from
their offerings through April 18, compared with 10 percent for
the Standard Poor’s 500 Index, according to data compiled by
The various provisions in the bill mean investors may be
offered more questionable investments, said Cox, the securities
“There’s going to be more low-quality offerings than there
were before,” he said. “Very, very high risk.”
To contact the reporters on this story:
Margaret Collins in New York
To contact the editors responsible for this story:
Rick Levinson at firstname.lastname@example.org